As the range gets wider, investing gets harder

There are lots of things that could happen; but only one thing that will happen. This is one of the better articulations out there of the concept of risk. Understanding risk is at the core of any investment because substantially all investments could result in a range of possible outcomes. Sometimes that range is narrow and sometimes that range is wide.

A wide range of possible outcomes makes life particularly difficult for investors. Here is how to think about it: imagine you could predict the future with a very high degree of confidence around a very narrow range of possible outcomes. You could fairly easily position your investments to do well under this scenario – even if the scenario itself was negative.

But when the range of possible outcomes is wide, it is much more difficult to position your portfolio is a way that will be ok under all possible scenarios. The range of possible outcomes is wide today. Here are two very plausible scenarios for global equities: one good and one bad. We’ll get the bad one out of the way first.

The US-China relationship deteriorates over issues like trade, technology and territorial claims to such a large extent that the Chinese banking system and economy sharply deteriorates, taking down with it the global economy. The US election in 2020 swings to a complete Democratic clean-sweep of the White House, the House and the Senate, almost certainly ensuring a reversal of the Trump corporate tax cuts.  Now this is a pretty scary scenario for global equity investors and by no means the most likely scenario – but it is far from impossible. If you knew this scenario would play out, you would fairly conclude that equities were generally overpriced today.

Here’s a much better scenario. Global central banks move to an easing bias (already happening) at the same time President Trump relaxes all tariffs in the lead-up to the 2020 election. Simultaneously, the German government fiscally stimulates its economy – as does the UK following Brexit – and the chance of a reversal of the Trump corporate tax cuts remains low. Under this scenario, equities all around the world soar. Said another way, if you knew this scenario would play out, you would fairly conclude that equities were generally under-priced today.

It may be tempting to conclude that, in an environment with such a wide range of possible outcomes, it may best to sit this one out. Hold cash until we have some clarity over the future, for example. Well, this too could prove to be a dangerous strategy. In a world in which interest rates globally have fallen and are looking to remain lower for longer, holding cash through this period could result in missing out on a possible step-change in asset prices. This step-change is the mathematical result of assets being valued at structurally lower interest rates.

Investing is never easy – and this is particularly so today. As the range of possible investment outcomes widens, investors really need to conceptually ‘pressure-test’ how their portfolios would perform under all possible scenarios. And building a portfolio that does ok under all scenarios is probably not the portfolio that will be the highest performing under the scenario which ultimately plays out. But at least you will be able to sleep at night knowing that you have enough diversification and downside-protection in place so you can withstand whatever the US President tweets out next. And finally, you will be well positioned to take advantages of opportunities that come your way as a result.

Screen Shot 2015-11-11 at 12.08.48 pmAndrew Macken is Chief Investment Officer with Montaka Global Investments. To learn more about Montaka, please call +612 7202 0100.

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